4/30/2009 @ 6:00PM

Fixing The Housing Crisis

At the dawn of the 20th century, fewer than half of all households in the United States owned their own home. Fueled by rapid income growth during the 1920s, home ownership increased to 47.8% in 1930 from 46.5% in 1900 but then declined to 43.6% in 1940.

An obstacle to homeownership at that time was the extant system of mortgage finance. Mortgage loans were supplied by mortgage bankers and savings and loan companies. Mortgage bankers financed their loans by selling bonds, generally to insurance companies, but also sold mortgage participation bonds to individuals during the 1920s. Savings and loans’ deposits were used almost exclusively to make mortgage loans.

First mortgages were typically short-term loans of often three to five years and for no more than 50% of the value of the property. Interest rates were variable, and only interest was paid during the term of the loan; there was no amortization. A balloon repayment of the principal or refinancing was required when the loan matured. Many borrowers obtained second and even third mortgages to finance their housing purchases.

A housing boom during the 1920s was accompanied by rapid appreciation of house prices. However, the subsequent housing and economic bust created problems for homeowners. Loss of employment made refinancing mortgages difficult. House price deflation forced foreclosures, primarily by the issuers of second and third mortgages who saw the value of their liens eroded by deflation.

Reform of mortgage finance and ending the loss of homes were the intended results of numerous legislative acts during the 1930s. A significant reform was the 1933 creation of the Home Owners Loan Corporation. This agency forestalled foreclosures for middle- and lower-income homeowners. The HOLC was financed by the sale of government-guaranteed bonds. It acquired mortgages that were in default and converted them to long-term, generally 20-year, loans with monthly payments of interest and principal at fixed rates of interest.

Although it stopped lending in 1935, the institution of the long-term, fully amortized, fixed-interest-rate mortgage dramatically altered mortgage finance, significantly contributing to the growth in homeownership following World War II.

The creation of the Federal Housing Administration in 1934 was intended to make the government’s mortgages marketable. The FHA insured the long-term, fixed-rate mortgages to facilitate the flow of funds into mortgage finance. The FHA initially insured mortgages up to 80% of the property value, a much higher loan-to-value ratio than previously allowed for first mortgages.

However, financial institutions were not aggressive purchasers of FHA-insured mortgages, so the
Federal National Mortgage Association
(
Fannie Mae
) was formed in 1938 to create a market for FHA and later Veteran Administration mortgages.

Creation of the Federal Savings and Loan Insurance Corporation in 1934, insuring deposits in savings and loan companies, benefited mortgage finance since deposits in savings and loans, the primary mortgage lenders, were fully guaranteed by the federal government.

Another 1930s regulation was Regulation Q. First applicable to commercial banks, this regulation prohibited the payment of interest on checking deposits and capped the rates of interest payable on savings deposits and certificates. This regulation was extended to savings and loans and savings banks in 1966. However, these thrift institutions were provided a competitive advantage by being allowed to pay one-quarter percent more (25 basis points) on savings instruments than commercial banks.

Deposit insurance and interest rate regulations allowed savings institutions to make mortgage loans at relatively low rates of interest, thereby subsidizing homeownership. However, the competitive benefits of regulation Q were quickly undermined by rising inflation, weakening the finances of savings institutions and eventually resulting in the savings and loan crisis.

The 1930s reforms of mortgage finance resulted in an increase of homeownership to 63% of households by 1970. Subsequent innovations, such as securitization, further increased the homeownership rate to 66% by 2000. However, more recent financial innovations, which increased homeownership to 69% of households in 2005, revived past practices and created new ones that recreated the instability in mortgage finance that existed prior to the 1930s reforms. These include increased reliance on adjustable rate mortgages, interest-only loans and even negative amortization loans. Payments for this last loan type do not cover monthly interest charges, so principal increases monthly, requiring refinancing when certain loan-to-value limits are attained, and thereby increasing monthly payments on the new, higher-valued loan.

Historically, the housing cycle is a primary component of any business cycle, with the current crisis being one of the worst cases. Past reforms of mortgage finance generally sought to increase homeownership and stabilize the housing cycle, and with it the business cycle. However, recent practice has undermined many of these reforms. Certainly new financial reforms and regulations are forthcoming. The objectives should be making homeownership feasible for those who can afford it and to stabilize the housing market to minimize economic fluctuations.

James L. Butkiewicz is a professor of economics at the University of Delaware, where he specializes in the Great Depression.